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Rising Earnings, Rising Costs


Companies have been reporting first quarter earnings that have generally been above analysts' estimates. So far of the 190 S&P 500 companies that have reported earnings, 78.4% have exceeded estimates with only 10.5% failing to achieve analysts' forecast. Additionally, those companies that are beating estimates are doing so by an average 6.8%. First Call now estimates that first quarter earnings will advance 21% over the first quarter last year with revenue up 9%. Besides strong results, several other common threads are apparent. These include, the weaker dollar continued to help multi-national companies, higher commodity prices, and an increase in employment activity.

Higher fuel prices are ruining what would be considered a recovery in the airlines. Continental reported that passenger revenue rose 11.5%. The company said that "had jet fuel prices been at Continental's five-year average (1999 to 2003) price, the company's fuel expense for the quarter would have been $102 million less." That is a very significant increase considering that it spent a total of $333 million on aircraft fuel and related taxes.

Higher dairy costs seem to be a theme throughout the food and restaurant sectors. CEC Entertainment, operator of Chuck E. Cheese, said its food costs increased by $1.1 million due to a 36% increase in cheese prices compared to last year. Kraft missed analysts, estimates primarily due to higher commodity costs. The company said that higher commodity cost negatively impacted EPS by a nickel. According to the company, cheese costs ended the first quarter at $2.06 per pound, which is almost double the price last year and closed at $2.17/pound on April 19, a record. Other commodity prices that Kraft cited include: soybean oil up 49% from last year, wheat up 44%, and Arabica coffee up 24%. The company reported that it is noticing the affects of the low-carb diet craze. It experienced single-digit increases in cheese, meat, and nuts, while biscuits and cereal lines had declines.

P.F. Chang's China Bistro is also wrestling with rising costs. On Wednesday, the casual-dinning chain said that underestimated the costs of implanting its new health benefits plan for hourly workers. It also said that due to rising food and labor expense it would not rule out a menu price increase later this year.

Labor costs continue to escalate. Knight Ridder reported that while salaries increased less than 1%, its wages and benefits expense increased by 5.4% due to a 43.5% increase in pension expense. Increases in newsprint are also weighing on results. Newsprint expense increased 4.2% even through consumption fell 0.8%. Knight reported that, "January was flat, February was up 1.0%, and March was up 5.3%." It is important to remember that last year March was significantly worse than January and February, being down 2.3% compared to up 1.9% and 1.1% respectively. With that said, the results do appear to be getting better. If 2002 is used as the base year, March results are up 2.9% from 2002 while January's results were 1.9% better than January 2002 and February was 2.1% better.

Several newspapers reported that advertising revenue improved throughout the quarter. Tribune also saw business increase on a month-over-month basis during the first quarter. It also experienced a gain in help wanted advertising. The New York Times saw ad revenue advance 3% in the first quarter with March ad revenue 9% ahead of last year. It also saw in increase in help wanted advertising. Gannett said during its conference call that it sees a difference in help wanted advertising based on if the area'economy is manufacturing based or service. It said its Michigan properties, some in Ohio are still struggling with help wanted advertising, but areas such as Fort Myers, Westchester, Rochester, are seeing double-digit growth in help wanted advertising.

Results from Kelly Services confirm the rebound in the labor market. Its revenue grew 15.5% in the first quarter compared to last year. This was the strongest year-over-year growth since the second quarter of 1997. US commercial staffing revenue increased 8.9% year-over-year, more than twice the rate of growth in the fourth quarter of 2003.

J.B. Hunt reported that revenue increased 8.2% in the first quarter, with most of the strength coming from intermodal, which rose 13%. The company commented that the first quarter was unusually strong, "Uncharacteristically brisk demand in January and February, blended wit the typically solid volumes in March, combined with good safety results, helped propel us to profit levels that normally occur during the busier part of the year."

More companies are growing earning through financing their consumers. Everyone is familiar with General Motors and Ford deriving a significant, if not majority, of their income from their financial subsidiary. Polaris Industries, one of the leading ATV and snowmobile manufactures, increased operating income by 34.4%. A substantial portion of this growth came from financial services. Income from financial services jumped 86% to $8.1 million from $4.4 million last year. This $3.7 million increase accounted for nearly two-thirds of the growth in operating income. Additionally, it jumped from contributing about 26% of operating income to 36%. At least Polaris still derives the majority of its income from selling its product instead of financing it. General Motors made $786 million from financing activity and $611 million from selling vehicles.

Johnson Controls reported that its revenue jumped 20%, with favorable currency translation accounting for about one-third of its revenue growth. Its strong revenue growth should come to little surprise since its end markets included the auto sector. It forecasts North American vehicle production to be 15.9 million units this year. This is about 9% higher than the 17.3 million units General Motors is predicting.

Most retailers and consumer oriented companies are doing very well, including the luxury end of the retailing spectrum. Coach reported that earnings rose 76% in the first quarter with sales advancing 42%. Its same store sales increased 20.5%. One area of retail that is clearly lagging is the toy makers. Both Mattel and Hasbro reported revenue weak revenue growth. Hasbro revenue growth was only 2.4%, with the U.S. Toys segment actually falling slightly. Hasbro blamed this on retailers not restocking inventory at the same rate customers were buying. Mattel posted a 5% increase in revenue, but all the growth was due to favorable currency exchange rates. Its domestic sales declined 1%.

Whirlpool announced earnings on Wednesday and increased its forecasts for US appliance shipments. It now expects shipments to increase 4% this year. This led Prudential Securities to increase earnings forecasts for this year and next year. However, with a looming increase in interest rates, the target price was maintained at $58 and the stock is currently trading at almost $67.

The run of strong economic data that started with the blow-out March employment report and was followed by March retail sales have caused economists to revise their estimates for when the Fed will begin the tightening cycle. Economists that previously didn't think it would happen until 2005 are now predicting that the move could be as early as August. How the economy and stock market reacts to higher interest rates will be very interesting and will certainly make for an interesting rest of the year. Homebuilders have already had their stock prices reduced in anticipation that housing will slow once rates tick up.

The quick rise in interest rate over the past couple weeks has dampened refinancing activity. The Mortgage Bankers Association index of refinance activity dropped almost 40% in the last two weeks. However, it has done little to stop homebuyers. After dropping almost 10% in the week ending April 9, applications for purchases actually increased a little last week. The trend continues to be toward adjustable rate mortgages. The percent of applications that were for ARMs increased to 31.7%. This is the highest percent since the January 2000 when it hit 34.4% and was marked the peak. As I have mentioned before, previously the increase in the percent of ARMs as correlated with and increase in mortgage rates. From early 1999 to mid-2000, the average interest rate on a 15-year mortgage jumped from about 6.5% to just over 8%. While rates have been volatile over the past year, the interest rate on the average 15-year mortgage is roughly were it was at the beginning of 2003. We continue to think this is an indication that homebuyers are stretching to purchase a house that they cannot afford utilizing traditional financing. Plus the anecdotal stories regarding Pay-Option ARMs makes the residential real estate market precarious.

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